Falling rates renew old problem for U.S. banks

By Jonathan Stempel - Analysis

NEW YORK (Reuters) - A plunge in U.S. interest rates to levels not seen since Dwight Eisenhower's presidency means troubled banks must cope with an old problem they thought they had licked.

The yield fell below 2.7 percent this week for the first time since 1955 on the benchmark 10-year Treasury note. That happened after Federal Reserve Chairman Ben Bernanke said the central bank might buy longer-term Treasuries to help pull the economy out of a year-long recession.

An improved economy could help banks by limiting credit losses from the housing slump and other consumer and commercial debt, as banks work to reduce risk on their balance sheets, or deleverage. Capital infusions from the Treasury Department's $700 billion bailout package could also ease rate pressures.

Yet falling long-term rates make it harder for banks to boost lending margins -- the difference between what a bank earns on loans, and pays on deposits and to borrow -- and make money.

That could weigh on earnings after a July-to-September period that was the industry's second-worst quarter for profit since 1990.

"For banks to function properly, risk has to be priced into loans," said Paul Miller, a Friedman, Billings, Ramsey & Co analyst. "As the system delevers, rates are going to rise, but that doesn't mean the government can't push rates low now to get the system back on its feet."

THE FEAR BID

Worries that the global economy is in a long and deep recession has pushed investors to sell stocks and credit products, and flee to the relative safety of U.S. Treasuries.

That has driven down the closing spread between two-year and 10-year Treasuries from 2.62 percentage points on November 13 to 1.78 on Tuesday, the lowest since September 26.

In contrast, the average high-quality corporate bond yields 6.5 percentage points more than Treasuries, and the average junk bond 20.2 percentage points more than Treasuries, according to Merrill Lynch data.

"The fear bid has compressed all Treasury yields, I think through fair value," said Mark MacQueen, co-founder of Sage Advisory Services Ltd in Austin, Texas, which invests $7 billion. That hurts banks because "the steeper the curve, the better," he said.

Banks have compensated in part by raising tens of billions of dollars in cheap funds by selling debt backed by the Federal Deposit Insurance Corp's temporary liquidity guarantee program.

Bank of America Corp (BAC.N), Citigroup Inc (C.N), Goldman Sachs Group Inc (GS.N), JPMorgan Chase & Co (JPM.N), Morgan Stanley (MS.N) and Wells Fargo & Co (WFC.N) are among lenders to conduct more than $37 billion of such sales. Much of this debt yields in the vicinity of a mere 3 percent.

Even so, narrower margins would damage a sector that posted a mere $1.7 billion in profits in the third quarter, according to the FDIC. Stockholders have also felt pain. The Standard & Poor's Financials Index .GSPF is down more than two-thirds since peaking on May 23, 2007.

"Margin pressures do create issues with regard to profitability," said Keith Leggett, senior economist at the American Bankers Association. "There aren't many good prospects as to where banks can make up lost net revenue."